Deck 3: The New Regulatory Environment and the Regulatory Dialectic

Question 1

Discuss agency problems for financial institutions including:
(1) Asymmetric information; (2) Adverse Selection; (3) Moral Hazard; and
(4) Conflicts of Interest problems for financial institutions.
For the U.S. Subprime Loan Crisis, discuss how these agency problems may have contributed to the crisis.

Answer 1

Given the nature of operations for financial institutions with financial contracts between parties, common problems include:
(1) Asymmetric Information, the inequality of information between savers and borrowers and financial institutions given the private nature of financial contracts and for at times incomplete information about future prospects of borrowers.
(2) Adverse Selection, a higher likelihood that potential customers that are more un-credit worthy or that take on greater risks are more likely to seek out financial products, such as loans and insurance.
(3) Moral Hazard, the risk or hazard that a borrower once having received a loan or insurance policy, for instance might be tempted to engage in undesirable and risk-taking activities that increase the risk that a loan might not be paid back or that an insurance company will have to payout more than expected for future losses.
(4) Conflicts of Interest when a party in a financial contract has incentives
to act in his/her own interests versus the interests of other parties.
During the U.S. Subprime Loan Crisis, a good example of asymmetric information was the bundling together of subprime loans for securitizations that were very complex with little information available on the quality of individual loans within a securitization. This led to credit analysts not being able to carefully analyze issues and giving too high credit rating for risky securitizations.
Adverse selection was also evident during the financial crisis with low documentation loans attractive to borrowers who were more risky applying for low doc loans, increasing the risk of these loans.
Moral hazard was also evident with subprime borrowers buying houses that they could not afford with the intent on speculating on them by flipping them after house prices rose in the future to be able to pay back the loan. When housing prices collapsed instead, many of these speculative borrowers walked away from their loans.
Conflicts of interest was rampant during the U.S. Subprime Loan Crisis with lenders receiving fees for making large volumes of loans versus accessing the quality of the loans made, leading to poor underwriting decisions and taking on large volumes of risky, subprime loans. Conflicts of interest were also evident with credit agents receiving fees and continued business with favorable ratings.

Question 2

What are ways that financial institutions can reduce the agency problems discussed in question 1? How is this being done under the Dodd-Frank Act and Basel III?

Answer 2

Financial institutions help to reduce these problems by providing information, analysis, and monitoring services, and designing contracts that reduce these problems. To help to avoid adverse selection and moral hazard problems for instance, insurance policies may include a large deductible, whereby an insurance policyholder has a stake in taking precautions and reducing potential risks. Similarly, requiring a significant down payment or setting the loan up with a higher loan to value ratio for a borrower taking on a home mortgage loan, gives a borrower a stake in to reduce incentives for the borrower to walk away from the loan.
Under Dodd-Frank, new regulations attempt to reduce information asymmetries between consumers and financial institutions by establishing the Bureau of Consumer Financial Protection for greater consumer finance protection and oversight. Dodd-Frank also includes more stringent oversight regulation and capital requirements for over the counter derivatives, and credit rating agency reform, and regulations for the securitization market. Other regulations apply greater corporate governance rules for executive compensation for financial institutions, and the registration of advisers of private funds, among others.
Basel III includes higher capital requirements, quality of capital rules, and new capital conservation and countercyclical capital buffers and risk coverage in terms of strengthening the capital treatment for complex securitizations and more rigorous credit analysis for securitization exposures that are externally rated, higher capital for trading and derivatives activities, strengthening the counterparty credit risk framework and risk weights for banks to hold more capital exposure to central counterparties.
Basel III also requires supplemental capital for off-balance sheet risk exposure and securitization activities, along with better incentives in place for better risk management over the long-term including sound compensation practices, valuation practices, and stress testing accounting for financial instruments and improved corporate governance. Under market discipline, Basel III also revised disclosure requirements for securitization exposure and the sponsorship of off balance sheet vehicles.

Question 3

Why do financial institutions need to understand central bank operations?

Answer 3

Financial institutions, and particularly depository institutions whose net interest margins are affected by changes in interest rates, need to understand and anticipate central bank operations including open market operations for expansion and contraction policies. Depository institutions are also part of the payments mechanism and have central bank regulations to abide by including reserve requirements and other regulations for the safety and soundness of the payments and banking system.

Question 4

Why are financial institutions regulated by governments?

Question 5

In the U.S. who are the different regulators?

Question 6

What are common types of regulation for banks?

Question 7

Explain in your own words Kane's regulatory dialectic and give a historical example for U.S. depository institutions, showing the different stages of the regulatory dialectic.

Question 8

Give an example of a regulatory dialectic occurring historically or today.

Question 9

What is involved in the bank examination process? Give a brief example for the U.S. depository institution examination process.

Question 10

Why is it important to have a central bank for a country?

Question 11

What are the roles of Central Banks?

Question 12

What are different tools used by central banks for expanding and contracting the money supply?

Question 13

Explain how central banks engage in expansionary and contraction using open market operations, and use the loanable funds curves to explain how interest rate targets are affected.

Question 14

Show the changes on the balance sheets for the non-bank public, banking system, and central bank with an expansionary policy by a central bank of $500 billion, and explain how it is carried out.

Question 15

Show the changes on the balance sheets for the non-bank public, banking system, and central bank with a contraction policy by a central bank of $500 billion, and explain how it is carried out.

Question 16

Explain how quantitative easing has been used in recent years, including a discussion of Operation Twist used by the U.S. Fed.

Question 17

Discuss the tradeoff between moral hazard and safety and soundness considerations for rescuing or not rescuing large financial institutions.

Question 18

Give an overview of Dodd-Frank Regulations.

Question 19

Give an overview of Basel I, II, and III and criticisms, and improvements that were made.

Question 20

Explain the Living Will requirement for 8 of the largest U.S. banks.

Question 21

The Federal Reserve System was set up as a decentralized system with 12 Federal Reserve Banks spread across the country, so all regions of the country would be represented.

Question 22

Bank panics in 1819, 1837, 1857, 1873, 1884, 1893, and 1907 occurred in the U.S. suggesting which of the following:

A) Free and wild-cat banking worked well to protect against bank panics.
B) A gold standard was useful to contain panics.
C) A central bank for the U.S. was needed to help prevent future panics.
D) None of the above.

Question 23

In the U.S., the Fed's operating target when implementing open market operations is:

A) The Fed's discount rate
B) The Fed Funds rate
C) Commercial bond rates
D) The Eurobond rate

Question 24

If a Central Bank wants to engage in an expansionary open market operation to increase the money supply it will:

A) Sell securities to the non-bank public
B) Increase bank reserve requirements
C) Purchase securities from the non-bank public
D) Raise the discount rate for banks to borrow from the central bank

Question 25

The Fed Funds rate used as target rate for the Fed's open market operations is which of the following:

A) The discount rate for banks to borrow from the Fed.
B) The borrowing rate for short-term Fed funds among banks.
C) The rate on U.S. Treasury Bills
D) The tax rate for banks

Question 26

A strong argument for having a central bank that is independent from government operations is that the central bank should not be under political pressure to increase the money supply, which would give monetary policy an inflationary bias.

Question 27

If the Fed conducts an expansionary open market operation to stimulate the economy purchasing $200 billion of securities, which of the following statements is false:

A) Non-bank public assets will change with - $200 bil. Securities and
+ $200 bil. Deposits held with banks
B) Non-bank public assets will change with + $200 bil. Securities and
- $200 bil. Deposits held with banks
C) The purchase of securities from the non-bank public will increase bank deposits as liabilities allowing banks to use these to make more loans.
D) The Central Bank's Assets will include a rise in Securities by $200 bil. and its liabilities will have a $200 bil. rise in reserves

Question 28

If a Central Bank wants to implement a contraction open market policy to reduce the money supply, which of the following statements is false:

A) The Central Bank will sell securities to the non-bank public, which will change the non-bank publics assets by + Securities and - Deposits with Banks.
B) The Central Bank will buy securities from the non-bank public, which will change the non-bank public assets by + Securities and - Deposits with Banks.
C) The supply of loanable funds curve will shift inward intersecting with the demand curve for loanable funds at a higher real equilibrium interest rate.
D) The reduction in non-bank public at banks will reduce deposits held as a liability by banks and reduce deposits available for banks to make loans.

Question 29

Quantitative easing differs from traditional open market operations by:

A) Involving purchasing very large amounts of securities from banks or the non-bank public for the purpose of increasing the money supply and providing a larger stimulus.
B) At times involving the purchase, such as with Operation Twist by the Fed long-term government securities and mortgage-backed securities to try to reduce long-term rates to encourage borrower by firms for capital projects to increase hiring and reduce unemployment.
C) Dramatically lowering the real interest rate in an economy.
D) All of the above.

Question 30

Which of the following is false for why financial institutions are regulated:

A) To ensure safety and soundness in the financial system
B) To protect consumers against fraud and misrepresentation given information asymmetries between consumers and financial institutions
C) To help financial institutions to adopt risky practices.
D) To promote efficiency and liquidity for the financial payments system.

Question 31

Ways financial institutions attempt to reduce adverse selection and
Moral hazard problems include which of the following:

A) Charging higher premiums to all customers
B) Providing information analysis, monitoring services, and designing contracts to reduce these problems
C) Having a large deductible for an insurance policy or a significant down payment for a loan where by customers have a stake
For respectively reducing risks and incentives not to walk away from a loan
D) Both b. and c.
E) Both a. and b.

Question 32

Which of the following is not a part of the uniform rating system for examinations of depository institutions in the U.S.?

A) Capital
B) Assets
C) Management
D) Adversity
E) Earnings, Liquidity, and Sensitivity to Market & Interest Rate Risk

Question 33

Which of the following is not a problem that can occur for countries that do not have a central bank?

A) An unsatisfactory currency that leads to fraud and an unredeemable currency
B) A deficit payment system making it difficult to verify a currency for payment
C) A country losing geographical territory with legal disputes
D) Periodic panics associated with currency crises and a lack of regulation for banks with no curbs in risk taking activities and fraud that result in widespread bank failures, contagion, and a widespread recession or depression
E) Having lack of control over the money supply leading to inflation
F) Having no lender of last resort in the event of bank panics and contagion across healthy banks

Question 34

Which of the following are provisions of the U.S. Dodd-Frank Act:

A) Creation of the Bureau of Consumer Financial Protection
B) Ending too big to fail bailouts
C) Advance warning systems: The Financial Stability Oversight Council
D) Executive compensation and corporate governance provisions
E) All of the above

Question 35

Regulators in deciding whether to close a large failing institution
Have to consider which of the following:

A) The moral hazard risk of large financial institutions taking on great risks, knowing that they are too big to fail if large FIs are rescued
B) Safety and soundness considerations in terms of contagion effects of a large financial institution's failure on other financial institutions and systemic risk for the financial system
C) Both of the above
D) None of the above

Question 36

Which statement is correct about Kane's Regulatory Dialectic?

A) The regulatory dialectic involves bank managers' relationship with customers
B) The regulatory dialectic involves getting rid of all regulations
C) The regulatory dialectic assumes banks obey all regulations
D) Stages of the regulatory dialectic include a thesis, such as the passage of regulations for safety and soundness, an antithesis such as banks finding ways to avoid regulations, and a synthesis, such as technology making previous regulations obsolete or reducing bank efficiency leading to lobbying for changes and eventual deregulation to improve the efficiency of the banking system

Question 37

Types of bank regulations include which of the following:

A) Balance sheet regulations and capital regulations
B) Central bank related regulations and requirements
C) Consumer protection regulations and social policy regulations
D) Safety/soundness regulations and examinations
E) All of the above

Question 38

Which of the following is not a U.S. bank regulatory agency?

A) The Federal Trade Commission
B) The Federal Reserve
C) The Office of the Comptroller of the Currency
D) The Federal Deposit Insurance Corporation
E) All of the above

Question 39

Regulatory changes under Basel III do not include which of the following:

A) New capital requirements and types of capital to hold with greater emphasis on the quality of capital, and new capital conservation and counter-cyclical capital buffers
B) A strengthening of capital treatment for certain complex securitizations and more rigorous capital analysis for securitization exposures that are externally-rated and higher capital for trading and derivative activities
C) A stronger non-risk based leverage capital ratio and a new liquidity coverage ratio and net stable funding ratio
D) Supplemental capital requirements for off-balance sheet risk exposure and securitization activities and revised disclosure requirements for securitization exposure and the sponsorship of off balance sheet vehicles
E) Breaking up banks larger than $100 billion

Question 40

Which of the following statements is correct concerning the regulation of U.S. insurance companies under the McCarran-Ferguson Act of 1945?

A) Under the McCarran Ferguson Act of 1945, the federal government has the potential right to regulate insurance companies, but does not exercise that right, if individual states adequately establish and enforce standards for the industry.
B) Under the McCarran Ferguson Act of 1945, only the federal government is allowed to regulate insurance companies.
C) Under the McCarran Ferguson Act of 1945, state insurance commissioners can never be interfered with even if states are inadequately establishing and enforcing standards for the industry.
D) None of the above.

Question 41

Which of the following is true about credit unions?

A) They are stock owned and can issue new stock for financing.
B) Their earnings are taxable.
C) They have a common bond requirement.
D) They have a large percentage of commercial loans.

Question 42

Advantages for stock ownership for a savings institution includes:

A) Limited liability for stockholders
B) Greater ability to raise external capital for growth and expansion
C) Both a and b
D) Double taxation

Question 43

According to Kane's regulatory dialectic, the process of
Modification of regulation in response to financial institution's reaction to prior regulation, is known as:

A) The thesis
B) The antithesis
C) The non-thesis
D) The synthesis

Question 44

Insurance companies in the U.S. are primarily regulated by:

A) State Regulators
B) Federal Regulators
C) Federal Deposit Insurance Corporation
D) Office of the Comptroller of Currency

Question 45

The Security and Exchange Commission (SEC) is responsible for:

A) Ensuring that full and accurate information is provided by those offering new securities to the public
B) Monitoring the frequency and accuracy of financial reports
C) Ensuring that pension funds are fully vested
D) a & b
E) All of the above